French President François Hollande's fiscal agenda suffered a setback Saturday, when France's Constitutional Council deemed his flagship 75% tax on incomes over €1 million unconstitutional. It therefore won't be in 2013's tax code, which is good news for those high earners that haven't yet left the country. But they're not in the clear: Government officials pledged to revisit the tax in 2014's budget, and the new version could very well be even tougher than the original.
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The council struck down the tax not because its rate was too high (and economically absurd), but because it didn't bite enough people. "Equality" is one of France's founding principles, and French law requires tax policy to uphold this. According to the council, a supertax on individual incomes over €1 million violates the equality principle because income taxes must be levied on households, not individuals. Imagine two French families of four earning €1.3 million annually under the proposed system. In one, the lady of the house rakes in €1.3 million on her own, so €300,000 gets taxed at 75%. But in the other, Madame makes €700,000 and her husband earns €600,000, so the portion over €1 million would be subject to ordinary income tax rates. Two equally sized families with equal incomes, but one pays less. In the council's view, both should pay the same.
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The revised tax could therefore aim the 75% rate at household incomes over €1 million (some speculate the threshold might rise to €2 million), though it's not certain whether Hollande has the political clout to pull this off. Hollande won the presidency despite his lifelong unpopularity and widely perceived fecklessness—polls suggested voters would have elected any mainstream candidate not named Nicolas Sarkozy. But he chose to interpret his four-point margin of victory as a mandate to hike taxes on businesses and wealthy folks, and these were star features of 2013's budget. But stagnant economic growth during his brief tenure and widespread worries about France's competitiveness (not to mention falling approval ratings) forced a small U-turn—in November, he offered businesses €20 billion in tax breaks over the next three years. Now his approval ratings are in the cellar, legislators from his Socialist party are losing confidence—one questioned whether the party is still "competent"—and French media has cast him as the emperor with no clothes. The more he flounders, the worse it gets. Hence he may decide abandoning the supertax despite its 60% approval rating is safer than risking further political embarrassment.
In our view, that would be the preferable outcome for France. More than anything, France needs growth. Not just to break out of its recent economic funk, but to narrow its deficit. Not that France is in dire need of deficit reduction—its 4.5% of GDP gap in 2012 wasn't gargantuan—but the Maastricht Treaty and new fiscal compact (which gives the Maastricht Treaty teeth) limit member-state deficits to 3% of GDP. Economic growth is the best way to narrow a budget gap. High taxes are often counterproductive, as even the IMF reminded France last week.
Perversely, though it was included in a deficit-reduction package, Hollande and his government never saw the high-income supertax as a deficit reduction measure. They only expected it to contribute €200 million to €500 million of the projected €20 billion revenue increase in 2012. Rather, it was a symbolic measure, framed as a way for France's wealthy to show "patriotism" by contributing more in times of need. But all it did was give France's wealthiest—including some of its most famous native sons and daughters—incentive to leave the country or cap their incomes. This likely leaves a rather large gap of lost income and economic activity. If France were to change course by lowering tax rates and making the country an overall friendlier place to do business, the economic activity and output it would gain would likely boost tax revenue far more than painful tax hikes would. France would be better positioned fiscally and economically, with everyone arguably better off (not to mention happier).
Time will tell what 2013 holds for French fiscal policy. But as we said when Hollande was elected, it's a stretch to think markets and voters will allow all his campaign pledges to come to fruition. A high income tax that falls victim to politicking might just set a market-friendly precedent to start 2013 (though we're not exactly holding our breath).
source: Market Minder
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